A credit sale is a type of transaction where the buyer delays payment to a later date. The seller usually decides on this date when they make a sale. Even if the buyer pays in cash at a later date, it is still not a cash sale. A cash sale is when a buyer pays for goods and services at the time of purchase. For example, if I go to a computer shop on July 1st and purchase a laptop with a promise to pay for the computer on July 31st, then it is a credit sale. In a credit sale, the buyer can pay at a later time using any acceptable form of currency: bills, credit cards, checks, etc. As a seller, you have to trust that the customer will pay for the item at the agreed time.
Terms Used In Credit Sales
Imagine you are selling a game to a friend who does not have the cash to pay for it at the moment. There is also no agreement on when he will pay you for the game — you just gave it to him assuming he’ll give you the money eventually. If your friend is unreliable, you might as well call the game a gift. He may never pay you!
The same thing happens in business. If a company sells on credit to customers and there are no terms for the credit sale, it means that the customers can pay the debt anytime they choose — which may be never.
To minimize such unwanted situations, sellers usually have credit sales terms that include the time when the debt will be due for payment, a discount duration, and a discount. Credit terms are written as:
a/b net c
Where a is the discount a customer can receive if the buyer pays the debt within the discount duration.
b is the discount duration,
c is the time when the credit will mature, and the customer will pay for the sale. At this point, the customer receives no discount.
For example, a credit term of 2/10 net 30 means that the buyer will get a discount of 2% if they make payment within the first ten days. The total time to pay for the item is 30 days.
Recording Credit Sales
A business records credit sales using journal entries. Journal entries are one of the most widely used account recording formats for sales. For credit sales, the recording involves creating account receivables for the company. Take a look at the general format below.
Amount is the total amount that can be received for a credit sale. Sales is the name of the item or items that are sold on credit.
If, during payment, the customer receives a discount for paying within the discount time, the discount is also included in the journal entry.
On December 1st, a computer retailing company, Com A, made a credit sale of 42 computers to a software company, Com B. The total credit sale was $63,000. The terms of the credit sale were 2.5/10 net 30. Com B paid $20,000 to Com A on December 5th to take advantage of the 2.5% discount. On December 31st, Com B paid another $36,000 to Com A.
Let’s break this down by first creating journal entries for credit sales in December.
The first step is to record the credit sale before the payments were made.
|Accounts Receivable (Com B)||$63,000|
The next step is to record the next part payment that was made by Com B. Com B paid $20,000 during the first ten days, which attracts a discount of 2.5%.
2.5% of $20,000
0.025 * $20,000 = $500
So the actual amount Com B paid was $20,000 – $500 = $19,500. It will be recorded as:
|Account Receivable (Com B)||$20,000|
Note that the cash discount is also recorded as part of account receivable from Com B.
Com B also made another part payment on December 31st, a sum of $36,000. However, this time, there is no discount because it is outside the discount duration. This second payment is recorded below.
|Account Receivable (Com B)||$36,000|
I guess you are saying in your mind that Com B did not finish paying their debt to Com A within the terms of the credit sale, and you are correct. The total amount paid by Com B is $20,000 + $36,000 = $56,000 which is $7000 less than the $63,000 debt. This debt is recorded below.
|Bad Debts (Com B)||$7,000|
Com A has recorded a loss of $7,000, which will most likely be written off as a bad debt and deducted as an expense from the income statement.
Advantages of Credit Sales
If you have a business and want to sell on credit, here are some ways you may benefit.
- When a company sells on credit, it attracts new customers who would otherwise not buy from the company. This is mostly true for companies that sell expensive items.
- Credit sales allow customers, especially business customers, to generate cash on the commodity before paying the seller. An example is when you buy a car on credit and use it for Uber and then pay back using the proceeds from Uber driving. Without credit sales, you will most likely not have the cash to pay for a new car.
- Selling on credit increases the sales volume of a company since the number of customers will increase.
Disadvantages of Credit Sales
Selling on credit is not all rosy. You should be mindful of the pitfalls below!
- When selling on credit, there is a chance that the customer may go bankrupt and fail to pay you. The company will lose revenue. The company will also have to write off the debt as bad debt. Companies usually estimate the creditworthiness or index of a customer before selling to such a customer on credit.
- The responsibility of collecting debt is on the seller. This may involve huge resources and, therefore, a reduction in revenue. Most large companies have debt collection departments solely for recovering debts from their customers. If not, they have to hire debt collection services.
- Companies that sell most of their goods on credit may have to resort to borrowing to keep up production. This increases the company’s interest payments at the end of the year.
- Selling on credit requires you to keep two records, the first being the record of the credit sale and, subsequently, payments made by the customer. This means that more books will be required to keep all the records, which attracts higher bookkeeping expenses.
So, should you sell on credit? The best approach is to consider the advantages, the risks, and how much it will cost you to keep track of your debtors. Companies that sell capital intensive equipment are more likely to sell on credit, while companies that sell inexpensive items such as pencils are most unlikely to sell on credit.